UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2008

OR

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM                      TO                     .

STERLING FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Washington		91-1572822
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

111 North Wall Street, Spokane, Washington 99201
(Address of principal executive offices) (Zip Code)

(509) 458-3711
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ		Accelerated filer o		Non-accelerated filer   o (Do not check if a smaller reporting company)		Smaller Reporting Company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No þ

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date:

Class		Outstanding as of August 1, 2008
Common Stock ($1.00 par value)			52,065,358

 

 

STERLING FINANCIAL CORPORATION

FORM 10-Q
For the Quarter Ended June 30, 2008

TABLE OF CONTENTS

		Page
PART I — Financial Information			1
Item 1 Financial Statements (Unaudited)			1
Consolidated Balance Sheets			1
Consolidated Statements of Income			2
Consolidated Statements of Cash Flows			3
Consolidated Statements of Comprehensive Income			5
Notes to Consolidated Financial Statements			6
Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations			17
Item 3 Quantitative and Qualitative Disclosures About Market Risk			34
Item 4 Controls and Procedures			34
PART II — Other Information			36
Item 1 Legal Proceedings			36
Item 1a Risk Factors			36
Item 2 Unregistered Sales of Equity Securities and Use of Proceeds			36
Item 3 Defaults Upon Senior Securities			37
Item 4 Submission of Matters to a Vote of Security Holders			37
Item 5 Other Information			37
Item 6 Exhibits			37
Signatures			38
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PART I — Financial Information

STERLING FINANCIAL CORPORATION

		June 30,				December 31,
		2008				2007
		(Dollars in thousands)
ASSETS:
Cash and cash equivalents:
Interest bearing		$	100			$	10,042
Non-interest bearing and vault			180,641				184,436
Total cash and cash equivalents			180,741				194,478
Restricted cash			1,100				1,100
Investment securities and mortgage-backed securities (“MBS”):
Available for sale			2,023,306				1,853,271
Held to maturity			180,185				132,793
Loans receivable, net			9,219,919				8,948,307
Loans held for sale ($73,859 at fair value as of June 30, 2008)			82,413				55,840
Accrued interest receivable			56,322				63,649
Real estate owned and other collateralized assets, net			22,998				11,075
Office properties and equipment, net			90,750				93,467
Bank-owned life insurance (“BOLI”)			154,714				150,825
Goodwill			451,323				453,136
Other intangible assets			29,175				31,627
Mortgage servicing rights, net			7,559				9,042
Prepaid expenses and other assets, net			199,205				151,165
Total assets		$	12,699,710			$	12,149,775
LIABILITIES:
Deposits		$	7,987,831			$	7,677,772
Advances from Federal Home Loan Bank (“FHLB”)			1,881,973				1,687,989
Securities sold subject to repurchase agreements and funds purchased			1,245,569				1,178,845
Other borrowings			248,274				273,015
Cashiers checks issued and payable			8,504				764
Borrowers’ reserves for taxes and insurance			2,969				1,765
Accrued interest payable			37,190				40,209
Accrued expenses and other liabilities			109,216				104,086
Total liabilities			11,521,526				10,964,445
SHAREHOLDERS’ EQUITY:
Preferred stock, $1 par value; 10,000,000 shares authorized; no shares issued and outstanding			0				0
Common stock, $1 par value; 100,000,000 shares authorized; 52,008,761 and 51,456,461 shares issued and outstanding			52,009				51,456
Additional paid-in capital			896,469				892,028
Accumulated other comprehensive loss:
Unrealized losses on investment securities and MBS available-for-sale, net of deferred income taxes of $18,892 and $10,518			(32,215	)			(17,967	)
Retained earnings			261,921				259,813
Total shareholders’ equity			1,178,184				1,185,330
Total liabilities and shareholders’ equity		$	12,699,710			$	12,149,775

See notes to consolidated financial statements.

STERLING FINANCIAL CORPORATION

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2008				2007				2008				2007
		(Dollars in thousands, except per share data)
Interest income:
Loans		$	152,271			$	172,825			$	314,391			$	325,588
MBS			25,586				19,356				50,085				39,824
Investments and cash equivalents			2,785				1,880				5,149				3,551
Total interest income			180,642				194,061				369,625				368,963
Interest expense:
Deposits			57,438				70,666				120,308				134,386
Short-term borrowings			9,408				9,730				12,839				19,405
Long-term borrowings			19,677				24,625				50,272				45,516
Total interest expense			86,523				105,021				183,419				199,307
Net interest income			94,119				89,040				186,206				169,656
Provision for losses on loans			(30,987	)			(3,975	)			(68,130	)			(8,200	)
Net interest income after provision for credit losses			63,132				85,065				118,076				161,456
Non-interest income:
Fees and service charges			16,012				13,694				30,163				25,886
Mortgage banking operations			8,227				9,807				14,425				18,665
Loan servicing fees			697				410				549				1,093
Real estate owned and other collateralized assets operations			(238	)			(93	)			(344	)			(138	)
BOLI			1,747				1,717				3,213				3,264
Other			(947	)			(757	)			(1,346	)			(544	)
Total non-interest income			25,498				24,778				46,660				48,226
Non-interest expenses			72,447				69,891				144,554				135,560
Income before income taxes			16,183				39,952				20,182				74,122
Income tax provision			(4,508	)			(12,971	)			(5,631	)			(24,220	)
Net income		$	11,675			$	26,981			$	14,551			$	49,902
Earnings per share — basic		$	0.23			$	0.53			$	0.28			$	1.03
Earnings per share — diluted		$	0.23			$	0.52			$	0.28			$	1.02
Weighted average shares outstanding — basic			51,687,600				51,189,438				51,606,966				48,230,619
Weighted average shares outstanding — diluted			51,883,549				51,699,098				51,837,108				48,776,780

See notes to consolidated financial statements.

STERLING FINANCIAL CORPORATION

		Six Months Ended
		June 30,
		2008				2007
		(Dollars in thousands)
Cash flows from operating activities:
Net income		$	14,551			$	49,902
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for credit losses			68,130				8,200
Accretion of deferred gain on sale of branches			(404	)			(352	)
Net gain on sales of loans, investment securities and MBS			(10,370	)			(11,460	)
Stock based compensation			1,260				627
Excess tax benefit from stock based compensation			(830	)			(1,336	)
Stock issuances relating to 401(k) match			1,601				1,172
Other gains and losses			1,844				1,504
Increase in cash surrender value of BOLI			(3,213	)			(3,264	)
Depreciation and amortization			13,116				12,135
Change in:
Accrued interest receivable			7,327				2,123
Prepaid expenses and other assets			(36,870	)			(6,957	)
Cashiers checks issued and payable			7,740				(18,564	)
Accrued interest payable			(3,019	)			(2,221	)
Accrued expenses and other liabilities			3,165				(4,580	)
Proceeds from sales of loans originated for sale			598,665				676,063
Loans originated for sale			(588,218	)			(667,682	)
Net cash provided by operating activities			74,475				35,310
Cash flows from investing activities:
Change in restricted cash			0				25
Loans funded and purchased			(2,243,517	)			(2,376,666	)
Loan principal received			1,861,961				2,026,361
Proceeds from sales of other loans			(77	)			97,114
Purchase of investment securities			(26,655	)			(47,195	)
Proceeds from maturities of investment securities			10,934				23,379
Proceeds from sale of investments			0				5,609
Net cash and cash equivalents acquired			0				92,419
Purchase of BOLI			(686	)			0
Purchase of MBS			(384,349	)			0
Principal payments on MBS			155,707				125,963
Purchase of office properties and equipment			(4,536	)			(7,202	)
Sales of office properties and equipment			300				2,792
Improvements and other changes to real estate owned			(661	)			(9	)
Proceeds from sales and liquidation of real estate owned			3,028				106
Net cash provided by (used in) investing activities			(628,551	)			(57,304	)

See notes to consolidated financial statements.

STERLING FINANCIAL CORPORATION
Consolidated Statements of Cash Flows
(Unaudited)

		Six Months Ended
		June 30,
		2008				2007
		(Dollars in thousands)
Cash flows from financing activities:
Net change in transaction and savings deposits		$	(31,044	)		$	151,234
Proceeds from issuance of time deposits			2,487,222				1,547,770
Payments for maturing time deposits			(2,263,734	)			(1,939,136	)
Interest credited to deposits			117,615				119,812
Advances from FHLB			779,750				1,232,744
Repayment of advances from FHLB			(585,457	)			(1,213,095	)
Net change in securities sold subject to repurchase agreements and funds purchased			66,724				128,549
Net proceeds from other borrowings			0				23,000
Repayment of other borrowings			(24,000	)			(13,403	)
Proceeds from exercise of stock options			1,303				3,070
Excess tax benefit from stock based compensation			830				1,336
Cash dividends paid to shareholders			(10,074	)			(7,246	)
Other			1,204				70
Net cash provided by (used in) financing activities			540,339				34,705
Net change in cash and cash equivalents			(13,737	)			12,711
Cash and cash equivalents, beginning of period			194,478				178,565
Cash and cash equivalents, end of period		$	180,741			$	191,276
Supplemental disclosures:
Cash paid during the period for:
Interest		$	186,438			$	199,555
Income taxes			12,784				28,427
Noncash financing and investing activities:
Loans converted into real estate owned and other collateralized assets			14,290				57
Common stock issued upon business combination			0				302,754
Common stock cash dividends accrued			5,188				4,374
Deferred gain on sale of branches			0				804

See notes to consolidated financial statements.

STERLING FINANCIAL CORPORATION

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2008				2007				2008				2007
		(Dollars in thousands)								(Dollars in thousands)
Net income		$	11,675			$	26,981			$	14,551			$	49,902
Other comprehensive income:
Change in unrealized losses on investment securities and MBS available-for-sale			(34,325	)			(25,686	)			(22,622	)			(18,461	)
Less deferred income taxes			12,701				9,507				8,374				6,837
Net other comprehensive income			(21,624	)			(16,179	)			(14,248	)			(11,624	)
Comprehensive income		$	(9,949	)		$	10,802			$	303			$	38,278

See notes to consolidated financial statements.

Notes to Consolidated Financial Statements

1. Basis of Presentation:

The foregoing unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X as promulgated by the Securities and Exchange Commission. Accordingly, these financial statements do not include all of the disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements as disclosed in the annual report on Form 10-K for the year ended December 31, 2007. In the opinion of management, the unaudited interim consolidated financial statements furnished herein include all adjustments, all of which are of a normal recurring nature, necessary for a fair statement of the results for the interim periods presented.

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities known to exist as of the date the financial statements are published, and the reported amounts of revenues and expenses during the reporting period. Uncertainties with respect to such estimates and assumptions are inherent in the preparation of Sterling Financial Corporation’s (“Sterling’s”) consolidated financial statements; accordingly, it is possible that the actual results could differ from these estimates and assumptions, which could have a material effect on the reported amounts of Sterling’s consolidated financial position and results of operations.

In addition to other established accounting polices, the following is a discussion of recent accounting pronouncements:

In September 2006, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.” Under the provisions of EITF Issue No. 06-4, Sterling recognizes the amount that is owed current or former employees under split dollar BOLI. Sterling adopted the EITF 06-4 effective January 1, 2008, which resulted in a cumulative charge of $2.1 million to retained earnings.

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“FAS”) No. 157, “Fair Value Measurements” (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. In February 2007, FASB issued FAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“FAS 159”). FAS 159 provides a fair value measurement election for many financial instruments, on an instrument by instrument basis. Both FAS 157 and 159 became effective for Sterling as of January 1, 2008. See Note 9 for a discussion of their impact. Sterling applied FAS 159 to its loans held for sale in order to match changes in the value of the loans with the value of their economic hedges without having to apply complex hedge accounting.

In November 2007, the SEC issued Staff Accounting Bulletin 109, “Written Loan Commitments Recorded at Fair Value Through Earnings,” (“SAB 109”) regarding the valuation of loan commitments. SAB 109 supersedes SAB 105, and states that in measuring the fair value of a derivative loan commitment, the expected net future cash flows related to the associated servicing of the loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. SAB 109 was effective for Sterling as of January 1, 2008.

In March 2008, the FASB issued FAS 161, “Disclosures about Derivative Instruments and Hedging Activities,” an amendment of FAS 133. FAS 161 requires enhanced disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under FAS 133 and related interpretations, and how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. FAS 161 is effective for Sterling as of December 31, 2008. Sterling is currently evaluating the impact of FAS 161.

2. Allowance for Credit Losses:

The following is an analysis of the changes in the allowances for credit losses (in thousands):

		Six Months Ended June 30,
		2008				2007
Allowance for credit losses
Allowance — loans, January 1		$	111,026			$	77,849
Allowance for losses on loans acquired			0				15,029
Provision			68,131				8,200
Amounts written off			(17,466	)			(1,984	)
Recoveries			639				481
Transfers			38				59
Allowance — loans, June 30			162,368				99,634
Allowance — unfunded commitments, January 1			6,306				5,840
Acquired			0				266
Provision			53				0
Transfers			(38	)			(59	)
Allowance — unfunded commitments, June 30			6,321				6,047
Total credit allowance		$	168,689			$	105,681

Sterling recorded a provision for credit losses of $68.1 million and $8.2 million for the six months ended June 30, 2008 and 2007, respectively. The increase in the provision for credit losses was in response to an increase in the level of classified loans. Recently, Sterling, like many other financial institutions, has experienced deterioration in the credit quality of residential construction loans due to declining market values and weakness in housing sales in certain of its markets.

3. Other Borrowings:

The components of other borrowings are as follows (in thousands):

		June 30,				December 31,
		2008				2007
Junior subordinated debentures		$	245,274			$	270,015
Other			3,000				3,000
Total other borrowings		$	248,274			$	273,015

Sterling raises capital from time to time through the formation of trust subsidiaries (“Capital Trusts”), which issue capital securities (“Trust Preferred Securities”) to investors. The Capital Trusts are business trusts in which Sterling owns all of the common equity. The proceeds from the sale of the Trust Preferred Securities are used to purchase junior subordinated deferrable interest debentures (“Junior Subordinated Debentures”) issued by Sterling. Sterling’s obligations under the Junior Subordinated Debentures and related documents, taken together, constitute a full and unconditional guarantee by Sterling of the Capital Trusts’ obligations under the Trust Preferred Securities. The Trust Preferred Securities are treated as debt of Sterling. The Junior Subordinated Debentures and related Trust Preferred Securities generally mature 30 years after issuance and are redeemable at the option of Sterling under certain conditions, including, with respect to certain of the Trust Preferred Securities, payment of call premiums. Interest is paid quarterly or semiannually.

Details of the Trust Preferred Securities are as follows:

Maturity

Amount (in

Subsidiary Issuer

Issue Date

Date

Call Date

Rate at June 30, 2008

Thousands)

Sterling Capital Trust IX

July 2007

Oct 2037

N/A

Floating

4.10

%

$

46,392

Sterling Capital Trust VIII

Sept 2006

Sept 2036

N/A

Floating

4.41

51,547

Sterling Capital Trust VII

June 2006

June 2036

N/A

Floating

4.30

56,702

Lynnwood Capital Trust II

June 2005

June 2035

June 2010

Floating

4.58

10,310

Sterling Capital Trust VI

June 2003

Sept 2033

Sept 2008

Floating

5.98

10,310

Sterling Capital Statutory Trust V

May 2003

May 2033

June 2008

Floating

6.06

20,619

Sterling Capital Trust IV

May 2003

May 2033

May 2008

Floating

5.83

10,310

Sterling Capital Trust III

April 2003

April 2033

April 2008

Floating

6.12

14,433

Lynnwood Capital Trust I

Mar 2003

Mar 2033

Mar 2007

Floating

5.96

9,472

Klamath First Capital Trust I

July 2001

July 2031

June 2006

Floating

6.94

15,179

4.91

%*

$

245,274

On January 25, 2008, Sterling redeemed $24.0 million of Trust Preferred Securities that carried a 10.25% fixed-rate coupon. In April 2008, Sterling renewed its revolving credit agreement with Wells Fargo Bank, N.A. through April 30, 2009, in the amount of $10.0 million. Amounts drawn on this line of credit bear interest at either 1.5% above LIBOR, or 1% below the prime rate, at Sterling’s election, and are collateralized by the stock of Golf Savings Bank. As of June 30, 2008, no amounts were drawn on this line of credit.

4. Earnings Per Share:

The following table presents the basic and diluted earnings per share computations.

		Three Months Ended June 30,
		2008												2007
		Net				Weighted				Per Share				Net				Weighted				Per Share
		Income				Avg. Shares				Amount				Income				Avg. Shares				Amount
		(Dollars in thousands, except per share amounts)
Basic computations		$	11,675				51,687,600			$	0.23			$	26,981				51,189,438			$	0.53
Effect of dilutive securities:
Common stock options and restricted shares			0				195,949				0.00				0				509,660				(0.01	)
Diluted computations		$	11,675				51,883,549			$	0.23			$	26,981				51,699,098			$	0.52
Antidilutive options not included in diluted earnings per share							1,719,222												307,945

		Six Months Ended June 30,
		2008												2007
		Net				Weighted				Per Share				Net				Weighted				Per Share
		Income				Avg. Shares				Amount				Income				Avg. Shares				Amount
		(Dollars in thousands, except per share amounts)
Basic computations		$	14,551				51,606,966			$	0.28			$	49,902				48,230,619			$	1.03
Effect of dilutive securities:
Common stock options and restricted shares			0				230,142				0.00				0				546,161				(0.01	)
Diluted computations		$	14,551				51,837,108			$	0.28			$	49,902				48,776,780			$	1.02
Antidilutive options not included in diluted earnings per share							1,697,470												254,613

5. Non-Interest Expenses:

The following table details the components of Sterling’s total non-interest expenses:

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2008				2007				2008				2007
		(Dollars in thousands)								(Dollars in thousands)
Employee compensation and benefits		$	41,133			$	39,163			$	82,023			$	77,234
Occupancy and equipment			10,693				11,681				22,225				22,148
Data processing			5,168				4,176				10,487				8,373
Depreciation			3,507				3,341				7,071				6,536
Advertising			3,019				3,279				5,817				5,956
Insurance			1,926				513				3,638				908
Travel and entertainment			1,781				2,133				3,446				3,641
Amortization of core deposit intangibles			1,226				1,226				2,452				2,267
Legal and accounting			723				547				1,536				1,223
Goodwill litigation costs			105				1,132				255				1,312
Merger and acquisition costs			157				413				182				844
Other			3,009				2,287				5,422				5,118
Total		$	72,447			$	69,891			$	144,554			$	135,560

6. Segment Information:

For purposes of measuring and reporting financial results, Sterling is divided into five business segments:

•

The Community Banking segment provides traditional bank services through the retail and commercial banking groups of Sterling’s subsidiary, Sterling Savings Bank.

•

The Residential Construction Lending segment originates and services loans through the real estate division of Sterling’s subsidiary, Sterling Savings Bank.

•

The Residential Mortgage Banking segment originates and sells servicing-retained and servicing-released residential loans through loan production offices of Sterling’s subsidiary, Golf Savings Bank.

•

The Commercial Mortgage Banking segment originates, sells and services commercial real estate loans and participation interests in commercial real estate loans through offices in the western region primarily through Sterling Savings Bank’s subsidiary INTERVEST-Mortgage Investment Company (“INTERVEST”).

•

The Other and Eliminations segment represents the parent company expenses and intercompany eliminations of revenue and expenses.

During 2008, the operations of Sterling Savings Bank’s subsidiary, Action Mortgage Company, were realigned into the real estate division of Sterling Savings Bank, and the operations of Sterling Savings Bank’s subsidiary, Harbor Financial Services, Inc., were moved into the private banking department of Sterling Savings Bank. The financial results for the real estate division are reflected in the Residential Construction Lending segment, while the private banking department’s financial results are included in the Community Banking segment. For comparability purposes, prior period segment information has been restated to reflect this realignment.

The following table presents certain financial information regarding Sterling’s segments and provides a reconciliation to Sterling’s consolidated totals for the periods presented:

		As of and for the Three Months Ended June 30, 2008
						Residential				Residential				Commercial
		Community				Construction				Mortgage				Mortgage				Other and
		Banking				Lending				Banking				Banking				Eliminations				Total
		(Dollars in thousands)
Interest income		$	139,452			$	28,084			$	8,023			$	4,890			$	193			$	180,642
Interest expense			(63,474	)			(15,586	)			(4,559	)			0				(2,904	)			(86,523	)
Net interest income (expense)			75,978				12,498				3,464				4,890				(2,711	)			94,119
Provision for loan losses			(15,709	)			(13,641	)			(1,637	)			0				0				(30,987	)
Noninterest income			18,625				1,173				7,155				905				(2,360	)			25,498
Noninterest expense			(59,160	)			(2,965	)			(6,817	)			(2,395	)			(1,110	)			(72,447	)
Income before income taxes		$	19,734			$	(2,935	)		$	2,165			$	3,400			$	(6,181	)		$	16,183
Total assets		$	10,475,295			$	1,759,429			$	500,402			$	10,044				(45,460	)		$	12,699,710

		As of and for the Three Months Ended June 30, 2007
						Residential				Residential				Commercial
		Community				Construction				Mortgage				Mortgage				Other and
		Banking				Lending				Banking				Banking				Eliminations				Total
		(Dollars in thousands)
Interest income		$	141,225			$	45,179			$	5,448			$	2,044			$	165			$	194,061
Interest expense			(71,983	)			(24,967	)			(3,377	)			0				(4,694	)			(105,021	)
Net interest income (expense)			69,242				20,212				2,071				2,044				(4,529	)			89,040
Provision for loan losses			2,226				(6,126	)			(75	)			0				0				(3,975	)
Noninterest income			20,977				2,013				5,613				1,967				(5,792	)			24,778
Noninterest expense			(56,261	)			(2,206	)			(7,841	)			(2,417	)			(1,166	)			(69,891	)
Income before income taxes		$	36,184			$	13,893			$	(232	)		$	1,594			$	(11,487	)		$	39,952
Total assets		$	9,582,395			$	1,615,945			$	346,601			$	8,984			$	(90,278	)		$	11,463,647

		As of and for the Six Months Ended June 30, 2008
						Residential				Residential				Commercial
		Community				Construction				Mortgage				Mortgage				Other and
		Banking				Lending				Banking				Banking				Eliminations				Total
		(Dollars in thousands)
Interest income		$	284,102			$	61,102			$	16,170			$	7,924			$	327			$	369,625
Interest expense			(132,410	)			(34,747	)			(9,360	)			0				(6,902	)			(183,419	)
Net interest income (expense)			151,692				26,355				6,810				7,924				(6,575	)			186,206
Provision for loan losses			(28,794	)			(37,256	)			(2,080	)			0				0				(68,130	)
Noninterest income			33,999				2,158				12,120				1,923				(3,540	)			46,660
Noninterest expense			(118,253	)			(5,902	)			(13,264	)			(4,830	)			(2,305	)			(144,554	)
Income before income taxes		$	38,644			$	(14,645	)		$	3,586			$	5,017			$	(12,420	)		$	20,182
Total assets		$	10,475,295			$	1,759,429			$	500,402			$	$10,044				(45,460	)		$	12,699,710

		As of and for the Six Months Ended June 30, 2007
						Residential				Residential				Commercial
		Community				Construction				Mortgage				Mortgage				Other and
		Banking				Lending				Banking				Banking				Eliminations				Total
		(Dollars in thousands)
Interest income		$	268,378			$	86,346			$	9,990			$	4,235			$	14			$	368,963
Interest expense			(135,926	)			(48,275	)			(6,251	)			0				(8,855	)			(199,307	)
Net interest income (expense)			132,452				38,071				3,739				4,235				(8,841	)			169,656
Provision for loan losses			(1,746	)			(6,304	)			(150	)			0				0				(8,200	)
Noninterest income			39,833				3,751				11,133				4,174				(10,665	)			48,226
Noninterest expense			(108,030	)			(4,698	)			(15,627	)			(5,329	)			(1,876	)			(135,560	)
Income before income taxes		$	62,509			$	30,820			$	(905	)		$	3,080			$	(21,382	)		$	74,122
Total assets		$	9,582,395			$	1,615,945			$	346,601			$	8,984			$	(90,278	)		$	11,463,647

7. Stock Based Compensation:

The following is a summary of stock option and restricted stock activity during the six months ended June 30, 2008:

		Stock Options								Restricted Stock
						Weighted
						Average								Weighted
						Exercise								Average
		Number				Price				Number				Grant Price
Balance, January 1, 2008			2,067,401			$	21.13				85,000			$	33.17
Granted			251,000				17.79				182,000				17.79
Exercised / vested			(224,973	)			5.79				(21,250	)			33.17
Cancelled / expired			(72,736	)			22.45				0				0.00
Outstanding, June 30, 2008			2,020,692			$	22.40				245,750			$	21.78
Exercisable, June 30, 2008			1,525,942			$	21.52

At June 30, 2008, the weighted average remaining contractual life and the aggregate intrinsic value of stock options outstanding was 4.8 years and ($36.9) million, respectively, and exercisable was 4.5 years and ($26.5) million, respectively, and at December 31, 2007, was 4.6 years and ($9.0) million, respectively, and 4.3 years and ($3.7) million, respectively. As of June 30, 2008, a total of 1,578,249 shares remained available for grant under Sterling’s 2001, 2003 and 2007 Long-Term Incentive Plans. The stock options granted under these plans have terms of four, six, eight or ten years. The stock options and restricted shares granted during 2008 have four year vesting schedules. During the six months ended June 30, 2008 and 2007, the intrinsic value of options exercised were $2.5 million and $5.0 million, respectively, and fair value of options granted were $1.1 million and $3.2 million, respectively. The Black-Scholes option-pricing model was used in estimating the fair value of option grants. The weighted average assumptions used were:

		Six Months Ended
		June 30,
		2008				2007
Expected volatility			30	%			28% - 29	%
Expected term (in years)			4.3				4.7 - 6.0
Expected dividend yield			2.14	%			0.90% - 1.10	%
Risk free interest rate			2.93	%			4.65% - 4.81	%

     Stock based compensation expense recognized during the periods presented was as follows:

		Six Months Ended
		June 30,
		2008				2007
		(Dollars in thousands)
Stock based compensation expense:
Stock options		$	570			$	334
Restricted stock			690				293
Total		$	1,260			$	627

As of June 30, 2008, unrecognized equity compensation expense totaled $7.9 million, as the underlying outstanding awards had not yet been earned. This amount will be recognized over a weighted average period of 3.6 years.

8. Derivatives and Hedging:

As part of its mortgage banking activities, Sterling issues interest rate lock commitments to prospective borrowers on residential mortgage loan applications. Pricing for the sale of these loans is fixed with various qualified investors under both non-binding (“best-efforts”) and binding (“mandatory”) delivery programs.  For mandatory delivery programs, Sterling hedges interest rate risk by entering into offsetting forward sale agreements on MBS with third parties. Risks inherent in mandatory delivery programs include the risk that if Sterling does not close the loans subject to interest rate lock commitments, it is nevertheless obligated to deliver MBS to the counterparty under the forward sale agreement. Sterling could incur significant costs in acquiring replacement loans or MBS and such costs could have a material adverse effect on mortgage banking operations in future periods.

Interest rate lock commitments and loan delivery commitments to investors are off balance sheet commitments that are considered to be derivatives. As of June 30, 2008, Sterling had mandatory delivery commitments to sell mortgage loans to investors valued at $35.1 million, and held offsetting forward sale agreements on MBS valued at $28.4 million. As of December 31, 2007, Sterling did not have any loans subject to interest rate lock commitments under mandatory delivery programs. As of June 30, 2008 and December 31, 2007, Sterling had entered into best efforts forward commitments to sell $113.6 million and $41.3 million of mortgage loans, respectively.

Sterling enters into interest rate swap derivative contracts with customers. The interest rate risk on these contracts is offset by entering into comparable broker dealer swaps. These contracts are carried as an offsetting asset and liability at fair value, and as of June 30, 2008 and December 31, 2007, were $2.3 million and $1.6 million, respectively.

9. Fair Value:

On January 1, 2008, Sterling adopted FAS 159, which gives companies the option of carrying their financial assets and liabilities at fair value and can be implemented on all or individually selected financial instruments. Effective January 1, 2008, Sterling elected to apply FAS 159 on newly originated loans held for sale under mandatory delivery programs. After analyzing the effects of FAS 159 on held for sale loans, Sterling elected to apply FAS 159 to all newly originated held for sale loans effective April 1, 2008. The fair value election was made to match changes in the value of these loans with the value of their economic hedges. Loan origination fees, costs and servicing rights, which were previously deferred on these loans, are now recognized as part of the loan value at origination. There was no transition adjustment upon adoption.

On January 1, 2008, FAS 157 became effective for Sterling. This standard establishes a framework for defining and measuring fair value. The standard requires that one of three valuation methods be used to determine fair market value: the market approach, the income approach or the cost approach. To increase consistency and comparability in fair value measurements and related disclosures, the standard also creates a fair value hierarchy to prioritize the inputs to these valuation methods into the following three levels:

•		Level 1 inputs are a select class of observable inputs, based upon the quoted prices for identical instruments in active markets that are accessible as of the measurement date, and are to be used whenever available.
•		Level 2 inputs are other types of observable inputs, such as quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are inactive; or other inputs that are observable or can be derived from or supported by observable market data. Level 2 inputs are to be used whenever Level 1 inputs are not available.
•		Level 3 inputs are significantly unobservable, reflecting the reporting entity’s own assumptions regarding what market participants would assume when pricing a financial instrument. Level 3 inputs are to only be used when Level 1 and Level 2 inputs are unavailable.

The following disclosure requirements under FAS 157 are applicable to financial assets and liabilities, and as of January 1, 2009, will be expanded to include nonfinancial assets and liabilities.

Assets and Liabilities Measured at Fair Value on a Recurring Basis. The following presents Sterling’s financial instruments that are measured at fair value on a recurring basis:

		June 30, 2008				Level 1				Level 2				Level 3
		(Dollars in thousands)
Investment securities and mortgage-backed securities available for sale		$	2,023,306			$	0			$	2,023,306			$	0
Loans held for sale			73,859				0				73,859				0
Other assets — derivatives			3,069				0				819				2,250
Total assets		$	2,100,234			$	0			$	2,097,984			$	2,250
Other liabilities — derivatives		$	2,312			$	0			$	62			$	2,250

Changes in the fair value of available-for-sale securities are recorded on the balance sheet under accumulated-other-comprehensive income, while gains and losses from sales are recognized as income. The difference between the aggregate fair value and the aggregate unpaid principal balance of loans held for sale that are carried at fair value under FAS 159 was $1.0 million as of June 30, 2008. Changes in fair value relating to these loans were included in earnings as follows:

		Six Months Ended
		June 30, 2008
		(Dollars in thousands)
Mortgage banking operations		$	1,010

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis. Sterling may be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis from application of lower of cost or market (“LOCOM”) accounting or write-downs of individual assets. For these financial assets for which a fair value adjustment was recorded during the period, the following table presents the adjustment and the carrying value at period end:

																		Losses During
																		the Six Months
		Total Carrying																Ended June 30,
		Value				Level 1				Level 2				Level 3				2008
		(Dollars in thousands)
Loans		$	74,141			$	0			$	74,141			$	0			$	(36,763	)
Mortgage servicing rights			3,558				0				3,558				0				(503	)
Real estate owned			12,898				0				12,898				0				(4,047	)

The loan loss disclosed above represents the amount of the specific reserve that was allocated to impaired loans during the period, and is included in the provision for credit losses. Mortgage servicing rights were written down mainly due to an acceleration of mortgage prepayments. Sterling carries its mortgage servicing rights at LOCOM, and as such, they are measured at fair value on a nonrecurring basis. The real estate owned charge during the period represents the writedowns taken at foreclosure that were charged to the general loan loss allowance.

10. Cash Dividends:

The following table presents the amount of dividends paid during the three and six months ended June 30, 2008 and 2007, respectively:

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2008				2007				2008				2007
		(Dollars in thousands, except per share amounts)
Total amount		$	5,186			$	4,093			$	10,075			$	7,251
Per share amount			0.100				0.080				0.195				0.155
Payout ratio			45	%			15	%			69	%			15	%

On July 11, 2008, Sterling paid a quarterly cash dividend of $0.10 per share of common stock to shareholders of record as of June 30, 2008.

11. Goodwill Lawsuit:

In April 2008, the U.S. Government appealed the U.S. Court of Federal Claim’s February 19, 2008 ruling that awarded damages to Sterling in the amount of $1.05 million resulting from Sterling’s lawsuit against the U.S. Government for breach of contract with respect to the loss of goodwill treatment and other matters relating to Sterling’s past acquisitions of troubled thrift institutions. Sterling has filed a notice of cross appeal. The U.S. Government and Sterling have jointly requested that the court assign a mediator to resolve the dispute.

PART I – Financial Information (continued)

STERLING FINANCIAL CORPORATION
June 30, 2008

This report contains forward-looking statements. For a discussion about such statements, including the risks and uncertainties inherent therein, see “Forward-Looking Statements.” Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes presented elsewhere in this report and in Sterling’s 2007 annual report on Form 10-K.

General

Sterling Financial Corporation (“Sterling”) is a bank holding company, organized under the laws of Washington in 1992. The principal operating subsidiaries of Sterling are Sterling Savings Bank and Golf Savings Bank. The principal operating subsidiary of Sterling Savings Bank is INTERVEST-Mortgage Investment Company (“INTERVEST”). During 2008, the operations of Sterling Savings Bank’s subsidiary, Action Mortgage Company, were realigned into the real estate division of Sterling Savings Bank, and the operations of Sterling Savings Bank’s subsidiary, Harbor Financial Services, Inc., were moved into the wealth management department of Sterling Savings Bank. Sterling Savings Bank commenced operations in 1983 as a Washington State-chartered federally insured stock savings and loan association headquartered in Spokane, Washington. On July 8, 2005, Sterling Savings Bank converted to a commercial bank. The main focus of Golf Savings Bank, a Washington State-chartered savings bank acquired by Sterling in July 2006, is the origination and sale of residential mortgage loans.

Sterling provides personalized, quality financial services and “Perfect Fit” banking products to its customers consistent with its “Hometown Helpful” philosophy. Sterling believes that its dedication to personalized service has enabled it to grow both its retail deposit base and its lending portfolio in the western United States. With $12.70 billion in total assets as of June 30, 2008, Sterling originates loans and attracts Federal Deposit Insurance Corporation (“FDIC”) insured deposits from the general public through 179 depository banking offices located in Washington, Oregon, California, Idaho and Montana. In addition, Sterling originates loans through Golf Savings Bank and Sterling Savings Bank residential loan production offices, and through INTERVEST commercial real estate lending offices throughout the western United States. Sterling also markets fixed income and equity products, mutual funds, fixed and variable annuities and other financial products through wealth management representatives located throughout Sterling’s financial service center network.

Sterling continues to implement its strategy to become the leading community bank in the western United States by increasing its commercial and consumer customer relationships that can provide a wider variety of lending opportunities, as well as increasing its commercial and retail deposits, particularly transaction accounts. Such loans generally involve a higher degree of risk than financing residential real estate. Management believes that a community bank mix of assets and liabilities will enhance its net interest income (the difference between the interest earned on loans and investments and the interest paid on deposits and borrowings) and will increase other fee income, although there can be no assurance in this regard. Sterling’s revenues are derived primarily from interest earned on loans and mortgage-backed securities (“MBS”), fees and service charges, and mortgage banking operations. The operations of Sterling, and banking institutions generally, are influenced significantly by general economic conditions and by policies of its primary regulatory authorities, the Board of Governors of the Federal Reserve System (the “Federal Reserve”), the FDIC and the Washington State Department of Financial Institutions.

Executive Summary and Highlights

Sterling’s earnings per share and performance ratios for 2008 were impacted by Sterling recording a credit provision that was higher than the provision recorded during 2007. During the first six months of 2008, Sterling has recorded a $68.1 million provision for credit losses compared with $8.2 million for the same period a year ago. This increase stems from higher levels of non-performing and classified assets, as disruptions in the financial and real estate markets have resulted in the exhaustion of liquidity reserves for some of Sterling’s borrowers. As of June 30, 2008, non-performing assets were $303.4 million versus $135.2 million at December 31, 2007, and $33.4 million at June 30, 2007. Sterling’s capital and liquidity sources remain strong, as well as the performance of its retail and commercial banking groups. Net interest income for the first half of 2008 was $186.2 million, versus $169.7 million for the six months ended June 30, 2007.

Highlights at June 30, 2008 as compared to June 30, 2007 were as follows:

•		Capital ratios remain above “well-capitalized” levels.
•		Net interest income rose 6% to $94.1 million.
•		Fees and service charge income grew 17% to $16.0 million.
•		Total deposits gained 5% to a record $7.99 billion.
•		Quarterly cash dividend was maintained at $0.10 per share.
•		Tangible book value per share increased 9% to $13.41.

Company Growth

Sterling intends to continue to pursue a long-term aggressive growth strategy to become the leading community bank in the western United States. In addition to continued organic growth, this strategy may include acquiring other financial businesses or branches thereof, or other substantial assets or deposit liabilities. There is no assurance that Sterling will be successful in completing any such acquisitions.

On February 28, 2007, Sterling completed its acquisition of Northern Empire Bancshares, a California corporation (“Northern Empire”) by issuing $30.0 million in cash, and 8,914,815 shares of Sterling common stock valued at $290.4 million in exchange for all outstanding Northern Empire shares. Northern Empire options totaling 646,018 were converted into 573,212 Sterling options, valued at $12.3 million. The total value of the transaction was $332.8 million. Northern Empire merged into Sterling, with Sterling being the surviving corporation in the merger. Northern Empire’s financial institution subsidiary, Sonoma National Bank, merged with and into Sterling’s subsidiary, Sterling Savings Bank, with Sterling Savings Bank being the surviving institution.

Sterling may not be successful in identifying further acquisition candidates, integrating acquisitions or preventing such acquisitions from having an adverse effect on Sterling. There is significant competition for acquisitions in Sterling’s market area, and Sterling may not be able to acquire other businesses on attractive terms. Furthermore, the success of Sterling’s growth strategy will depend on increasing and maintaining sufficient levels of regulatory capital, obtaining necessary regulatory approvals, generating appropriate growth and the existence of favorable economic and market conditions. There can be no assurance that Sterling will be successful in implementing its growth strategy.

Critical Accounting Policies

The accounting and reporting policies of Sterling conform to accounting principles generally accepted in the United States of America (“GAAP”) and to general practices within the banking industry. The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Sterling’s management has identified the accounting policies described below as those that, due to the judgments, estimates and assumptions inherent in those policies are critical to an understanding of Sterling’s Consolidated Financial Statements and Management’s Discussion and Analysis.

Income Recognition. Sterling recognizes interest income by methods that conform to general accounting practices within the banking industry. In the event management believes collection of all or a portion of contractual interest on a loan has become doubtful, which generally occurs after the loan is 90 days past due, Sterling discontinues the accrual of interest and any previously accrued interest recognized in income deemed uncollectible is reversed. Interest received on nonperforming loans is included in income only if principal recovery is reasonably assured. A nonperforming loan is restored to accrual status when it is brought current, has performed in accordance with contractual terms for a reasonable period of time, and the collectability of the total contractual principal and interest is no longer in doubt.

Allowance for Credit Losses. The allowance for credit losses is composed of the allowance for loan losses and the reserve for unfunded credit commitments. In general, determining the amount of the allowance requires significant judgment and the use of estimates by management. Sterling maintains an allowance for credit losses to absorb probable losses in the loan portfolio based on a quarterly analysis of the portfolio and expected future losses. This analysis is designed to determine an appropriate level and allocation of the allowance for losses among loan types by considering factors affecting loan losses, including specific losses, levels and trends in nonperforming loans, historical loan loss experience, current national and local economic conditions, volume, growth and composition of the portfolio, regulatory guidance and other relevant factors. Management monitors the loan portfolio to evaluate the adequacy of the allowance. The allowance can increase or decrease each quarter based upon the results of management’s analysis.

The amount of the allowance for the various loan types represents management’s estimate of expected losses from existing loans based upon specific allocations for individual lending relationships and historical loss experience for each category of homogeneous loans. The allowance for credit losses related to impaired loans is based on discounted cash flows using the loan’s initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. This evaluation requires management to make estimates of the amounts and timing of future cash flows on nonperforming loans, which consist primarily of non-accrual and restructured loans.

Individual loan reviews are based upon specific quantitative and qualitative criteria, including the size of the loan, loan quality ratings, value of collateral, repayment ability of borrowers, and historical experience factors. The historical experience factors utilized and allowances for homogeneous loans (such as residential mortgage loans, consumer loans, etc.) are collectively evaluated based upon historical loss experience, trends in losses and delinquencies, growth of loans in particular markets, and known changes in economic conditions in each particular lending market.

While management uses available information to provide for loan losses, the ultimate collectability of a substantial portion of the loan portfolio and the need for future additions to the allowance will be influenced by changes in economic conditions and other relevant factors. While Sterling did not participate in the lending practices that led up to the credit crisis, the effects of the current economic slow down has resulted in an increase in delinquencies and nonperforming assets in Sterling’s residential construction portfolio. A further slowdown in economic activity could have additional adverse affects on cash flows for both commercial and individual borrowers, which may result in further increases in nonperforming assets, delinquencies and losses on loans. There can be no assurance that the allowance for credit losses will be adequate to cover all losses, but management believes the allowance for credit losses was adequate at June 30, 2008.

Investment Securities and MBS. Assets in the investment securities and MBS portfolios are initially recorded at cost, which includes any premiums and discounts. Sterling amortizes premiums and discounts as an adjustment to interest income over the estimated life of the security. The cost of investment securities sold, and any resulting gain or loss, is based on the specific identification method.

The loans underlying Sterling’s MBS are subject to the prepayment of principal. The rate at which prepayments are expected to occur in future periods impacts the amount of premium to be amortized in the current period. If prepayments in a future period are higher or lower than expected, then Sterling will need to amortize a larger or smaller amount of the premium to interest income in that future period.

Management determines the appropriate classification of investment securities at the time of purchase. Held-to-maturity securities are those securities that Sterling has the positive intent and ability to hold to maturity and are recorded at amortized cost. Available-for-sale securities are those securities that would be available to be sold in the future in response to Sterling’s liquidity needs, changes in market interest rates, and asset-liability management strategies, among other factors. Available-for-sale securities are reported at fair value, with unrealized holding gains and losses reported in shareholders’ equity as a separate component of other comprehensive income, net of applicable deferred income taxes.

Management evaluates investment securities for other-than-temporary declines in fair value on a quarterly basis. If the fair value of investment securities falls below their amortized cost and the decline is deemed to be other-than-temporary, the securities will be written down to current market value, resulting in a loss recorded in the income statement and the establishment of a new basis. During the period ended June 30, 2008, there were no investment securities that management identified to be other-than-temporarily impaired, because the decline in fair value was attributable to changes in interest rates and not credit quality, and because Sterling has the ability and intent to hold these investments until a recovery in market price occurs, or until maturity. Realized losses could occur in future periods due to a change in management’s intent to hold the investments to recovery, a change in management’s assessment of credit risk, or a change in regulatory or accounting requirements.

Goodwill and Other Intangible Assets. Goodwill arising from business combinations represents the value attributable to unidentifiable intangible elements in the business acquired. Sterling’s goodwill relates to value inherent in the banking business and the value is dependent upon Sterling’s ability to provide quality, cost effective services in a competitive market place. As such, goodwill value is supported ultimately by revenue that is generated by the volume of business transacted. A decline in earnings as a result of a lack of growth or the inability to deliver cost effective services over sustained periods can lead to impairment of goodwill that could adversely impact earnings in future periods.

Due to the impact of market volatility on Sterling’s market capitalization as compared to its GAAP basis equity, Sterling is analyzing the value of goodwill related to its acquisitions to determine whether the value of goodwill has been impaired. Sterling anticipates that the analysis will be completed by the end of the third quarter. There are many assumptions and estimates underlying the determination of impairment. Future events could cause management to conclude that Sterling’s goodwill or other intangible assets are impaired, which would result in Sterling recording an impairment loss. Any resulting impairment loss could have a material adverse impact on Sterling’s financial condition and results of operations.

Other intangible assets consisting of core deposit intangibles with definite lives are amortized on a straight line basis over the estimated life of the acquired depositor relationships (generally eight to ten years).

Real Estate Owned and Other Collateralized Assets. Property and other assets acquired through foreclosure of defaulted mortgage or other collateralized loans are carried at the lower of cost or fair value, less estimated costs to sell. Development and improvement costs relating to such property are capitalized to the extent they are deemed to be recoverable.

An allowance for losses on real estate and other assets owned includes amounts for estimated losses as a result of impairment in value of the property after repossession. Sterling reviews its real estate owned and other collateralized assets for impairment in value whenever events or circumstances indicate that the carrying value of

the property or other assets may not be recoverable. In performing the review, if expected future undiscounted cash flow from the use of the property or other assets, or the fair value, less selling costs, from the disposition of the property or other assets is less than its carrying value, an impairment loss is recognized.

Loans Held for Sale. On January 1, 2008, Sterling adopted the fair value election available under FAS 159 for newly originated loans held for sale under mandatory delivery programs. Effective April 1, 2008 Sterling expanded its adoption of FAS 159 to all newly originated loans held for sale. The fair value election was made to match changes in the value of these loans with the value of their economic hedges without having to apply complex hedge accounting. Loan origination fees, costs and servicing rights are recognized as part of the loan value at origination. This value is based on quoted prices for similar instruments in both active and inactive markets, therefore, these loans are classified as level 2.

Income Taxes. Sterling estimates income taxes payable based on the amount it expects to owe various taxing authorities. Accrued income taxes represent the net estimated amount due to, or to be received from, taxing authorities. In estimating accrued income taxes, Sterling assesses the relative merits and risks of the appropriate tax treatment of transactions, taking into account the applicable statutory, judicial and regulatory guidance in the context of Sterling’s tax position. Sterling also considers recent audits and examinations, as well as its historical experience in making such estimates. Although Sterling uses available information to record income taxes, underlying estimates and assumptions can change over time as a result of unanticipated events or circumstances. Penalties and interest associated with any potential estimate variances would be included in income tax expense on the Consolidated Statement of Income.

Sterling uses an estimate of future earnings to support its position that the benefit of its net deferred tax assets will be realized. If future taxable income should prove nonexistent or less than the amount of temporary differences giving rise to the net deferred tax assets within the tax years to which they may be applied, the assets will not be realized and Sterling’s net income will be reduced.

Results of Operations

Overview. Sterling recorded net income of $11.7 million, or $0.23 per diluted share, for the three months ended June 30, 2008, compared with net income of $27.0 million, or $0.52 per diluted share, for the three months ended June 30, 2007. Net income for the six months ended June 30, 2008 was $14.6 million, or $0.28 per diluted share, compared to $49.9 million, or $1.02 for the same period in 2007. The annualized return on average assets was 0.37% and 0.94% for the three months ended June 30, 2008 and 2007, respectively. The annualized return on average equity was 3.9% and 9.6% for the three months ended June 30, 2008 and 2007, respectively. The year over year decrease in net income and performance ratios primarily reflected an increased credit provision in response to an increase in the level of classified loans, particularly in the residential construction portfolio.

Net Interest Income. The most significant component of earnings for a financial institution typically is net interest income, which is the difference between interest income, primarily from loan, MBS and investment securities portfolios, and interest expense, primarily on deposits and borrowings. During the three months ended June 30, 2008 and 2007, net interest income was $94.1 million and $89.0 million, respectively, an increase of 6%. Net interest income for the six months ended June 30, 2008 increased 10% to $186.2 million from $169.7 million for the six months ended June 30, 2007. The increase in net interest income from the growth in loan balances was partly offset by a decrease in net interest margin, which resulted from the yield on Sterling’s earning assets declining faster than the cost of deposits and borrowings, and an increase in nonperforming loans.

Changes in Sterling’s net interest income are a function of changes in both rates and volumes of interest-earning assets and interest-bearing liabilities. Net interest margin refers to net interest income divided by total average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities. The following table presents the composition of the change in net interest income, on a tax equivalent basis, for the periods presented. Municipal loan and bond interest income are presented gross of their applicable tax savings. For each category of interest-earning assets and interest-bearing liabilities, the following table provides information on changes attributable to:

•

Volume – changes in volume multiplied by comparative period rate;

•

Rate – changes in rate multiplied by comparative period volume; and

•

Rate/volume – changes in rate multiplied by changes in volume.

		Three Months Ended June 30,																Six Months Ended June 30,
		2008 vs. 2007																2008 vs. 2007
		Increase (Decrease) Due to:																Increase (Decrease) Due to:
										Rate/																Rate/
		Volume				Rate				Volume				Total				Volume				Rate				Volume				Total
Rate/volume analysis:		(Dollars in thousands)
Interest income:
Loans		$	15,572			$	(32,631	)		$	(3,489	)		$	(20,548	)		$	47,379			$	(51,886	)		$	(6,660	)		$	(11,167	)
MBS			5,069				961				200				6,230				8,178				1,637				446				10,261
Investments and cash equivalents			882				250				83				1,215				1,293				699				206				2,198
Total interest income			21,523				(31,420	)			(3,206	)			(13,103	)			56,850				(49,550	)			(6,008	)			1,292
Interest expense:
Deposits			6,071				(17,702	)			(1,597	)			(13,228	)			14,123				(25,874	)			(2,327	)			(14,078	)
Borrowings			9,804				(11,647	)			(3,427	)			(5,270	)			22,765				(18,341	)			(6,234	)			(1,810	)
Total interest expense			15,875				(29,349	)			(5,024	)			(18,498	)			36,888				(44,215	)			(8,561	)			(15,888	)
Changes in net interest income		$	5,648			$	(2,071	)		$	1,818			$	5,395			$	19,962			$	(5,335	)		$	2,553			$	17,180